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RETHINKING
THE GREAT DEPRESSION:
IMPLICATIONS FOR VALUE INVESTORS
Part I
1 April 2003
I’m told I can’t use the word depression. Well, I’ll tell you the definition. A recession is when your neighbour loses his job and a depression is when you lose your job. Recovery is when Jimmy Carter loses his.
Ronald Reagan
U.S. Presidential Election (1980)
Perhaps because we are three generations removed from it and the images it evokes are so unpleasant and discomfiting, the Great Depression seldom intrudes explicitly into our thoughts. At the same time, however, and in ways that are rarely recognised, certain beliefs and habits that most of today’s investors hold dear were moulded during the late 1920s and 1930s. Their conceptions of recession and depression; their views about the cause of the Great Depression; their opinions about what ended the Depression; and perhaps most importantly, their beliefs about the proper role, benevolence and general efficacy of government economic management – all have been strongly influenced if not determined by ideas and actions which gained currency between 1929 and 1945.
Unfortunately, however, and as Gene Smiley demonstrates in a new summary of research (Rethinking the Great Depression: A New View of Its Causes and Consequences, Ivan R Dee, 2002, ISBN: 1566634725), much of what we think that we know about the Depression may be false; and many of the lessons we have learnt from it may be mistaken. People act upon ideas, and the ideas adopted at critical junctures – whatever their correspondence to reality – tend to become deeply entrenched. Most of today’s politicians, economists and market participants think and act like their fathers and grandfathers. To do so usually makes good sense: we benefit immeasurably from the cultural and economic inheritance our forebears bequeathed to us.
But not all of our inheritance is sacrosanct, and for this reason Sean Corrigan’s recent injunction to investors and custodians of capital, entitled Six Myths of the Crash, is apposite. Given the tragic and enduring errors committed during the 1930s, today is “a time for the careful and conservative stewardship of [capital] and for those charged with this to display a willingness to challenge prevailing myths, whether these arise from economic sophistry or from institutional prejudice and intellectual inertia. If we can all become convinced that these are aims well worth achieving [then] this recession might actually turn out to have been fully worth the cost.”
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Mainstream Conceptions
A recession is conventionally defined as a rather short period of time, usually 6-18 months, during which the amount and pace of economic activity decreases modestly. Since the Second World War in Anglo-American countries, an increase in the rate of joblessness has usually accompanied a recession. A depression, in turn, is conventionally defined as an extended period of time during which business activity drops significantly. A high rate of unemployment and deflation allegedly occur in tandem with a depression. With the possible exception of New Zealand during the mid 1980s, no Western country has experienced a depression since the 1930s. The term “deflation,” as used by mainstream economists and commentators, refers to a decline in the general level of prices. Its cause can be direct, i.e., through a decrease of demand for goods and services (either in the form of a reduction of spending by governments, capitalists or consumers, or some combination of all three) or indirect, i.e., through a reduction in the supply of money or credit (see also Inflation and Deflation: Some Dissenting Thoughts for Value Investors). Deflation, it is said, is associated with an abrupt increase in the rate of unemployment.
The difference between the terms “recession” and “depression” is indistinct because the definition of neither term is universally agreed. If one asked a group of economists, financiers and business journalists to define them, it is likely that one would receive half a dozen or more separate categories of response. The definition of recession favoured by many journalists and commentators is a decline of Gross Domestic Product (GDP) during two or more consecutive quarters. Many economists dislike this definition because it excludes from consideration changes in other variables such as consumer confidence.
Further, if one relies upon quarterly data then it is rather difficult both to detect a recession and to pinpoint its commencement and termination. A sharp and painful contraction that lasts fewer than six months, for example, may either escape the notice of statisticians – or, given its short duration, fall outside the definition of recession. For this and other reasons, in the U.S. the Business Cycle Dating Committee of the National Bureau of Economic Research determines the extent and type of business activity by looking at a host of economic gauges. These include employment, production, income and wholesale and retail sales. NBER defines a recession as an interval of time between (a) the point when aggregate business activity reaches a peak and starts to fall and (b) the point when it reaches a floor and then begins once again to rise. By this definition, since the Second World War the average recession in the U.S. has lasted approximately 11 months.
Before the Great Depression, any downturn in economic activity, regardless of its length and severity, was called a depression. The term recession was subsequently developed in order to differentiate periods like 1920-21 and the 1930s from the less momentous economic declines that occurred in 1907, 1910 and 1913. Hence the simple but still vague definition of a depression: it is a recession that is unusually long-lived and entails a particularly sharp decline of business activity. How, then, to distinguish a recession and a depression?
A rule of thumb to which a plurality of the mainstream would likely assent is to focus upon changes of GDP. A depression is an economic downturn during which real GDP declines by more than 10 percent; and a recession is a less severe (in time or intensity) downturn. Using this rule of thumb, the last depression in the United States occurred between May 1937 and June 1938. During this 13-month interval real GDP declined by 18.2 percent. If we use this method then in the U.S. the Great Depression of the 1930s can be seen as two separate events: a depression of unprecedented severity that began in August 1929 reached its nadir in March 1933 (and during which real GDP declined by almost 33 percent); a period of recovery; and then a second, and mercifully less severe, depression in 1937-38.
By this method, nothing remotely resembling a depression has been experienced in the U.S. since the late 1930s. Countries such as Finland, Indonesia and possibly New Zealand, however, have suffered depressions during the past 10-15 years. America’s worst recession since the Depression occurred between November 1973 and March 1975: during this period real GDP fell by 4.9 percent. In an outstanding interview conducted in 1996, James Grant, publisher of Grant’s Interest Rate Observer, noted “central bankers may decry one form of inflation. But among the contributions of the Austrians is the insight that there can be an inflation of assets as well as an inflation of prices. In Wall Street and the financial press, inflation means one thing only: the CPI going up. But to students of the Austrian School, that isn’t even half of it.”
So too with the business cycle, recessions and depressions: aggregated national accounts and changes therein, which in various ways are unsatisfactory and incomplete (see, for example, Lawrence Parks, Burn Your House, Boost the Economy, Frank Shostak, What is Up With the GDP? and GNP and Consumer Confidence in Australia: A Dissenting Argument) are not even half of it.
...continued in Part II
RETHINKING
THE GREAT DEPRESSION:
IMPLICATIONS FOR VALUE INVESTORS
Part II
15 April 2003
...continued from Part I
Those readers who have not been introduced to recent scholarship on [this] subject may find some surprising conclusions. The Great Depression is often said to demonstrate the instability of market economies and the need for government oversight and direction. The evidence can no longer support such assumptions. Government efforts to control and direct the gold standard for national purposes brought on the Depression. Once it began, government actions, particularly in the United States, caused it to be much longer and much more severe [than it might otherwise have been]. When the contraction finally ended, government interference in U.S. markets brought on a ‘depression within a depression.’ The 1930s economic crisis is a tragic testimony to government interference in market economies.
Gene Smiley,
Rethinking the Great Depression (2002)
Another Conception of Depression
In a free society, the prices of goods and services are the primary means by which commercial considerations (such as a capitalist’s decision whether or not to build a factory, or a consumer’s decision whether or not to buy a particular good or service) are calculated. Millions of consumers, whose tastes differ from one another and whose preferences change over time, constantly choose among innumerable different commodities and services; similarly, hundreds of thousands of producers, in order to decide what and how much to produce and where to produce it, choose from countless possible resources and methods of production. Accordingly and more generally, prices are also the primary means by which the actions of capitalists, producers and consumers are co-ordinated.
No central planner or committee oversees these myriad choices and decisions. Quite the contrary – in a free society decision-making is decentralised to the level of the individual consumer and producer. Each consumer draws upon information that only she can know (such as her current and prospective income and budget, preference for one good or service vis-à-vis another and the next-best use of the resources at one’s disposal) in order to decide which combination of goods and services, and how much of each, she will purchase. Individual consumers’ purchases provide the revenues by which producers demand the resources necessary to produce the goods and services desired by consumers; and the payments to the owners of resources provide the incomes with which, as consumers, they can demand various commodities and services.
Prices co-ordinate these activities. (I, Pencil by Leonard Read is an outstanding elaboration of the indispensable role of the price system as a mechanism that co-ordinates the actions of myriad people.) More importantly, prices provide the means by which each individual contributes a sliver of knowledge to a whole that no one individual, committee or central planner can possibly command. As an example, if tastes change such that at given prices consumers demand more beef and less of other meats, then they will seek to purchase more beef and less beef-substitutes such as mutton, fish, pork, etc. If so, then the prices of beef will tend to rise and those of other meats will tend to fall. In response to the signals and hence economic incentives generated by these absolute and relative changes of prices, graziers and other primary producers will seek to produce more beef and less mutton, pork, poultry, and other types of meat.
To the extent that their capital base allows them, in other words, they will seek reallocation of resources away from the production of competing meats and towards the production of beef. Producers are unlikely to possess direct knowledge of consumer preferences and changes therein; indirectly, however, i.e., through the signals transmitted by prices and changes of prices, their incentives quickly change in a manner that is consistent with the alteration of consumers’ tastes. Also in response to these changes of absolute and relative prices, abattoirs will seek to ship more beef (and less mutton, etc.) to wholesalers; wholesalers will seek to ship more beef (and less mutton, etc.) to retailers; and retailers will seek to sell more beef and less of other meats to consumers.
A change in consumers’ preference for beef vis-à-vis other meats, then, has through the price mechanism generated commensurate changes to the structure or chain of production of this commodity from primary producers to final consumers. As with beef and other meats so too with myriad other goods and services: if in one market (say, beef) at the current price the quantity demanded by consumers exceeds the quantity supplied by producers, then in another market(s) at the current price(s) the quantity demanded will tend to be less than the quantity supplied. Changes in the absolute and relative prices in these markets will tend to induce producers and the owners of resources to shift production from the latter markets towards the former market. Price changes will also tend to induce consumers to shift from the former markets (where prices are tending higher) towards the latter market (where prices are stable or tending to fall). In this way prices and changes of prices enforce the sovereignty of consumers and the efficiency of producers. Prices co-ordinate the structure of production that harnesses the actions of producers to the demands of consumers. Countless marginal adjustments of prices and relative prices occur constantly. The effect of these adjustments is to allocate scarce resources towards the production of those goods and services (and in those quantities) that consumers desire.
Prices, then, are simple and content-rich bits of information that enable specialisation and exchange to occur. Prices are a necessary condition of a division of labour; and efficient and specialised exchange co-ordinates production and consumption. Clearly, information never corresponds perfectly to the preferences, incentives and behaviour that it measures; the movement of information through space is never instantaneous; and its interpretation is never flawless. Error and misjudgement, in short, is a necessary accompaniment of a price system. Yet the historical record – particularly an examination of attempts to fix, thwart or suspend prices – indicates that an unfettered system of prices generally works reasonably well (see, for example, Tom Bethell’s eminently readable The Noblest Triumph: Property and Prosperity Through the Ages, Palgrave Macmillan, 1998, ISBN: 0312210833).
A price system enables capitalists and producers to detect and adjust reasonably quickly and efficiently to changes in consumer demand. It also enables them to react to changes in the supply of various resources. In a free market, relative to a hampered market or no market, wastage and unemployment of resources is minimised. The price mechanism is a robust but not an indestructible mechanism. Because prices are the primary co-ordinating agents in a market economy, and because prices are expressed in monetary terms, it follows that disturbances to the monetary system may disrupt the price system’s ability properly to co-ordinate the actions of capitalists, producers and consumers. Indeed, a recession or depression occurs when something – particularly a monetary disturbance – disrupts the relatively smooth and accurate operation of price signals (see in particular Murray Rothbard, A History of Money and Banking in the United States: The Colonial Era to World War II, Ludwig Von Mises Institute, 2002, ISBN: 0945466331). The greater the extent and duration of the disruption, the less the extent to which owners and producers can accurately identify and respond to changes in consumer tastes.
RETHINKING
THE GREAT DEPRESSION:
IMPLICATIONS FOR VALUE INVESTORS
Part III
1 May 2003
...continued from Part II
To understand the nature of the worldwide Great Depression and the severity and greater length of the American contraction, one must … understand something of the nature and characteristics of money. Three essential features are banks and the creation and destruction of money; the role of the Federal Reserve System in creating and destroying money; and the gold standard and fixed exchange rates.
Gene Smiley,
Rethinking the Great Depression (2002)
A Primer on Fractional Reserve Banking
The essence of modern banking is arbitrage: banks borrow from a group of people who are in a position to supply funds (depositors) and lend to another but not completely disjoint group (borrowers) who demand funds. In order to compensate depositors for the use of their funds, banks pay them interest; and to compensate themselves for the risk that inheres in lending, banks charge interest on the funds lent to borrowers. To the extent that they arbitrage successfully, i.e., receive more interest from borrowers than is paid to depositors, and receive principal from borrowers and can return it to depositors, banking is a profitable exercise (see in particular Vera C. Smith, The Rationale of Central Banking and the Free Banking Alternative, The Liberty Fund, 1936, 1990, ISBN: 0865970866; Murray Rothbard, The Mystery of Banking and Murray Rothbard, A History of Money and Banking in the United States: The Colonial Era to World War II, Ludwig Von Mises Institute, 2002, ISBN: 0945466331).
A critical ingredient of banks’ success and failure is the creation and destruction of demand deposits. A modern bank lends what would otherwise be idle balances from depositors’ accounts by creating (or adding to) borrowers’ demand deposits. Borrowers then write cheques in order to spend the borrowed funds. Demand deposits facilitate commercial transactions and are an integral part of the money supply. A depositor’s signature on a cheque authorises his bank to pay a portion of his demand deposit to the bearer of the cheque. As Gene Smiley (Rethinking the Great Depression: A New View of Its Causes and Consequences, Ivan R Dee, 2002, ISBN: 1566634725) notes, there is a crucial difference between demand deposits and other types of money.
By the late nineteenth century, banks in America, Australia, Britain and other countries had generally become “fractional reserve” banks. When a bank clears a cheque it debits a demand deposit; and when a bank’s customer deposits funds into an account the bank credits the customer’s demand deposit. Most of the time, the amount of currency paid when cheques are cleared approximates (and thus offsets) the amount received in the form of new deposits. Given that it is safer and more convenient to hold one’s liquid funds in the form of a demand deposit in a bank rather than notes and coins stuffed under the mattress or buried in the back garden, under normal conditions it is unlikely that all or even many of a bank’s depositors will simultaneously seek to convert their demand deposits into currency. Hence the development of “fractional reserve” banking.
Fractional reserve banks retain only a fraction of their deposit liabilities in their vaults (i.e., in the form of currency reserves); instead, most of their deposit liabilities are lent to borrowers. Banks lend in order to generate the income required to pay the bank’s staff and other expenses, provide dividends for their shareholders and pay interest to their depositors. Other things equal (and assuming that the bank arbitrages successfully between depositors and borrowers and that many depositors will not simultaneously seek to convert their demand deposits into currency), the lower the fraction of deposits held in reserve the more profitable the bank. Hence the perennial risk that banks lend too aggressively (see in particular James Grant, Money of the Mind: Borrowing and Lending in America from the Civil War to Michael Milken, Noonday Press repr. ed. 1994, ISBN: 0374524017).
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A Stylised Example
Gene Smiley provides a stylised example that shows how fractional reserve banking can create (and destroy) money. Let us assume that a gold miner extracts gold nuggets that are worth $5,000, and that a local mint transforms them into $5,000 of gold coins. Also assume that the miner deposits the coins (i.e., converts the coins into a demand deposit with a balance of $5,000) at his local bank. For convenience let us refer to this bank as Bank A. Further, let us assume that the law requires that banks hold a minimum percentage of their deposits in cash reserves composed of either gold coins or currency (bank notes). More specifically, assume that banks are required to hold 12.5% of their deposits as reserves; that as a matter of practice banks retain some additional margin of reserves (above the required minimum) as a precaution against unexpected deposit withdrawals; and that therefore banks normally hold 15% of their deposits in gold and currency.
This amount sits either in the bank’s vault or is a demand deposit at another (probably larger) bank. Accordingly, Bank A would retain $750 of the miner’s $5,000 deposit in reserves and would seek to lend the remainder ($4,250) to creditworthy borrowers. If a borrower obtained a loan, then the bank would lend the money by creating a new demand deposit in the borrower’s name (or by adding to the borrower’s current demand deposit) of an amount equal to the loan. Once the bank had lent its new excess reserves of $4,250, it could make no new additional loans until it obtained additional excess reserves. As Smiley notes, however, the story does not end here.
For simplicity let us assume that a single manufacturing firm borrowed the entire $4,250 and that it used this amount to construct additional space at its factory. Assume as well that the firm that extended the factory received the cheque for $4,250 and that it deposited the cheque in its bank (which we will call Bank B). Bank B sends the cheque to Bank A, where $4,250 is deducted from the borrowing firm’s demand deposit and $4,250 (either in the form of currency, or, more likely a bank cheque) is sent to Bank B. Accordingly, Bank A no longer has excess reserves from the miner’s deposit of $5,000. But Bank B has. More precisely, on its balance sheet it now has a new liability (demand deposit) of $4,250 and new asset (additional cash reserves) of $4,250; but given that it holds 15% of deposits as reserves it will retain only $637.50 in reserves against this new deposit. Bank B can lend its new excess reserves of $3,612.50 by creating (or adding to) a demand deposit for a borrower. When a second borrower spends the $3,612.50 and his cheque clears Bank B, this bank (like Bank A) would have no excess reserves available for loans. But Bank C has. Let us say that the $3,612.50 cheque is deposited in a demand deposit in another bank, and that this bank is called Bank C. It now has excess reserves of $3,070.63 and can lend this amount by creating (or adding to) a borrower’s demand deposit.
Consider the process thus far. A miner has mined $5,000 worth of gold and, after having it struck into coins, deposits it in Bank A. The new $5,000 of gold has been converted into a new demand deposit of $5,000 and the money supply has increased by $5,000. Because banks keep only a fraction of their deposits in reserves, Bank A lent the excess reserves and those became a new demand deposit of $4,250 at Bank B. Bank B then had excess reserves, which became a new demand deposit of $3,612.50 at Bank C. In a fractional-reserve banking system, the “hard money” of $5,000 (i.e., the gold the miner found) has set in train a process that has increased demand deposit money by $12,862.50. Further, the process is not finished because Bank C now has excess reserves. This process of expanding the money supply through the creation of demand deposits can continue until all of the $5,000 in gold is transformed into required and precautionary reserves. Given our assumptions, the miner’s production of $5,000 of money could potentially increase the money supply by $33,333.33 (i.e., $5,000 ÷ 0.15). Fractional-reserve banking thus tends inherently to change the money supply; further, the smaller the reserve fraction the greater the resultant change of the money supply. Given this leverage, relatively small changes in reserves typically create much larger changes in the supply of money.
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Fractional Reserve Banking and Monetary Disturbance
Smiley cites an historical example to illustrate the problems that may arise – indeed, inhere – in fractional reserve banking. On 14 October 1907, an unusually large number of the depositors of five banks in New York City began to convert their demand deposits into currency. The depositors’ preference for currency over deposits exceeded the banks’ ability to convert deposits into currency: trouble at these institutions therefore brewed. On 21 October, the Knickerbocker Trust Co. experienced a severe “run” on its deposits and failed; and on 24 October, depositors at the second largest trust company in the City began a run on their deposits.
Chastened by this unexpected development, increasingly worried depositors at other banks began to convert their deposits into currency; in a chain reaction, increasingly concerned banks outside New York that held deposits with banks in the City now began to convert those deposits into currency and gold; and depositors at banks in other Eastern cities, observing the unfolding panic in New York, began to convert the deposits at their banks into currency. By late October 1907 a nation-wide banking panic had developed.
Under a fractional reserve banking system, banks cannot instantly pay cash to large numbers of their depositors because the bulk of the deposits are held in an illiquid form, i.e., loans and income-earning securities rather than currency and gold. And in the absence of a central or reserve bank, commercial banks can turn only to the strongest and most solvent among their ranks, if such a bank exists, in order quickly to obtain cash. If large numbers of banks sell their loans and securities in order to obtain cash for their panicky depositors, their concerted action would drive down the prices of the loan books and securities. Under these circumstances the banks would not have sufficient assets to cover their liabilities and would thus be bankrupt.
In 1907 J.P. Morgan’s rock-solid balance sheet and the confidence he and it inspired saved the day and eventually halted the panic. Banks were able to stem the redemption of deposits into currency and gold. They continued to clear cheques and borrowers continued to repay their loans. Just as they had ended previous banking panics, these actions ended the Panic of 1907 (as economic historians subsequently dubbed it). But in its immediate aftermath, as a safety precaution banks increased the percentage of their deposits they kept as cash reserves. And depositors, for a while, held more of their capital in currency and less in demand deposits.
To rebuild their reserves – for example, to increase the percentage of deposits held as reserves from 15% to 20% – banks must reduce their net lending. If borrowers repaid $100,000 of their outstanding loans, for example, then banks might create only $85,000 of new loans. They could do this by increasing interest rates or the terms and conditions of collateral and repayment, or by “calling” (i.e., demanding immediate repayment of) loans: either would reduce the demand for loans. Under these conditions the demand deposits “destroyed” by the repayment of old loans would be larger than the deposits “created” by new loans. Increasing the fractional reserve ratio thus tends to decelerate, halt or reverse the growth of the money supply. The miner’s new $5,000 in gold would result in $25,000.00 of new demand deposits at a 20% reserve ratio versus $33,333.33 at a 15% ratio. Further, and perhaps more importantly, at a 20% ratio each dollar that a depositor converted into currency rather than hold as a demand deposit would require that the banking system destroy $5 of demand deposits. At a 15% reserve ratio each dollar of demand deposits converted into cash required the destruction of $6.67 of demand deposits.
Under a regime of fractional reserve banking, then, relatively small changes in reserves eventually generate much larger changes in the money supply. In 1907 banks responded to the October runs by accumulating but not lending excess reserves. The money supply subsequently shrank, the pace of economic activity (which had hitherto depended upon debt finance) decelerated and prices (including the price of labour) fell precipitously. The rapid decrease of many prices, which was unrelated to the preferences and demands of consumers, drastically but temporarily weakened the ability of the price mechanism smoothly, accurately and efficiently to co-ordinate the actions of capitalists, producers and consumers. Only when the structure of production adjusted to these new and chastened conditions could prices transmit accurate signals, growth resume and prosperity return.
In 1907, then, a monetary disturbance and the institution of fractional reserve banking transformed what might otherwise have been a brief and relatively minor contraction into a rapid and severe decline of economic activity that persisted until June 1908. During the 1920s and early 1930s, much more severe, complex and extended monetary disturbances occurred. These disturbances, together with politicians’ and policymakers’ utter unwillingness to let the price mechanism operate freely, transformed what might have been a short and sharp contraction of a 1907 or 1920-21 type into a depression of unprecedented severity that lasted throughout the decade.
...continued in Part IV
RETHINKING
THE GREAT DEPRESSION:
IMPLICATIONS FOR VALUE INVESTORS
Part IV
15 May 2003
...continued from Part III
Central bankers, like generals, often are accused of fighting the last war. The [U.S.] Federal Reserve remains haunted by its most humiliating defeat – an utter failure not only to prevent the Great Depression, but its ineptitude in countering the most severe downward spiral in American economic history. That failure arguably has a profound impact on Fed policy to this day.
Barron’s (3 March 2003)
Most monetary economists, particularly those of the Austrian School, have observed the relationship between the supply of money and the pace and sustentation of economic activity. When the central bank increases the supply of money and credit, i.e., generates inflation, interest rates initially fall. Businesses invest this “easy money” and a boom, particularly in the capital goods sector, commences. As the boom matures businesses’ costs increase, interest rates readjust upward and profit margins are squeezed (see Interest Rates, Corporate Debt and the Business Cycle). These effects of central banks’ easy-money policy subsequently dissipate; and the monetary authorities, fearing price inflation, slow the growth of – or even contract – the money supply. In either case, the manipulation of interest rates distorts or falsifies price signals sufficiently to remove the shaky supports underlying the boom (see Inflation and Deflation: Some Dissenting Thoughts for Value Investors).
This crude outline of the business cycle applies (albeit imperfectly) to the late 1920s, late 1990s and other boom-bust sequences (see in particular Great Myths of the Great Depression by the Mackinac Centre for Public Policy). Hence the most fundamental (but hardly the sole) causes of the excesses of the business cycle, including the Great Depression, are fractional reserve banking and central banks. Murray Rothbard’s America’s Great Depression (1963, 2000, Ludwig von Mises Institute, ISBN: 0945466056) is perhaps the most thorough and meticulously documented account of the inflationary actions of the U.S. Federal Reserve during the 1920s. Using a broad measure that includes currency, demand and time deposits, Rothbard estimated that the supply of money in the U.S. grew more than 60 per cent between mid-1921 to mid-1929.
The breakneck expansion of money and credit constitutes what Benjamin Anderson (Economics and the Public Welfare: Financial and Economic History of the United States, 1914-1946, Liberty Fund, 1937, 1980, ISBN: 091396669X) called “the beginning of the New Deal.”
During the 1920s, American monetary authorities actively manipulated the business cycle. They sought to stimulate a boom at home and to assist the Bank of England’s desire to maintain the £ at the rate of exchange that prevailed before the First World War. The resultant flood of credit depressed interest rates, inflated the prices of securities to unprecedented levels and unleashed the “Roaring Twenties.” Producers and consumers made merry, and the Federal Reserve helpfully spiked the punch.
Rothbard shows how the relatively stable prices of the 1920s to a great extent masked the Fed’s inflation and thereby induced many people to think that the gilded prosperity could continue indefinitely. At the same time, technological advancements and entrepreneurial discoveries introduced cheaper ways to produce better goods for more people. This veritable explosion of productivity counteracted much of the upward pressure upon prices generated by the Fed’s policy of inflation. Alas, the distortions and “malinvestments” fostered by the inflation of the money supply cannot continue indefinitely. Every artificial expansion of money and credit introduces imbalances in economic relationships that send false price signals, induce a cluster of entrepreneurial and consumer error and thus set the stage for the downward leg of the business cycle (see, for example, Is Australia Really a Low-Inflation Country?).
This fall is made worse when, by the process outlined in Part III, an increase of the money supply is succeeded by a sudden and severe contraction.
In 1928, the Federal Reserve began to raise interest rates. Its discount rate (the rate charged to member banks for short-term loans) was increased four times, from 3.5 per cent to 6 per cent, between January 1928 and August 1929; and for the next three years it presided over a reduction of the money supply of approximately 30% (see also Milton Friedman and Anna Schwartz, A Monetary History of the United States, 1867-1960, Princeton University Press, 1971, ISBN: 0691003548; and Allan H. Meltzer, A History of the Federal Reserve: Volume 1: 1913-1951, University of Chicago Press, 2003, ISBN: 0226519996). Such a sharp deflation, following so quickly on the heels of the previous inflation, wrenched the economy from tremendous boom to colossal bust. A few analysts contend that the Fed intended this dreadful deflation, but most believe that it badly miscalculated. The result in either case was a manifest failure of monetary policy.
Yet the length and severity of the Great Depression cannot be laid solely at the feet of central bankers: they had much help from politicians. Rothbard’s America’s Great Depression details the many errors of Herbert Hoover (president from 1929 to 1933). His successor, Franklin D. Roosevelt, continued and compounded Hoover’s blunders. FDR was one of the first major political leaders to derive many of his most senior advisers from prestigious academic institutions. These intellectuals rejected the nineteenth century inheritance of black letter law, small government, laissez-faire and the gold standard. Instead, they believed that the U.S. should become a collectivist democracy and therefore that it should embark upon an extensive and intensive program of national economic planning and administrative discretion.
Confirming some people’s worst fears, Roosevelt moved very quickly to alter monetary arrangements radically. The government assigned to itself the authority to control all foreign exchange transactions and all movements of gold and currency. On 5 April 1933, FDR issued an Executive Order that compelled American citizens to surrender all gold certificates and physical gold (except for rare gold coins); on 18 April he prohibited the private export of gold and indicated he would fix the price of gold – an action that augured the devaluation of the $US; and on 5 June, Congress abrogated all gold clauses in contracts. To those who equated gold with money, the sanctity of contract with civil order and stable monetary arrangements with civilisation, the 5 June resolution was a catastrophe. Sen Elmer Thomas, an inflationist from Oklahoma, called it “the most important proposition that has ever come before any parliamentary body of any nation of the world” and rubbed his hands at the prospective transfer of wealth from creditors to debtors. For exactly the same reason, Sen Carter Glass remarked to a friend that “it’s a dishonour … This great government, strong in gold, is breaking its promises to pay gold to widows and orphans to whom it has sold government bonds with a pledge to pay gold coin of the present standard of value.” Sen Thomas Gore of Oklahoma was asked by FDR for an opinion on the gold-clause resolution before it was put to a vote. Quoth the Senator: “why, it’s just plain stealing, isn’t it, Mr President?”
The presidential election campaign of 1936 and the years 1936-1941 introduced overt class warfare into American politics (see also John T. Flynn, The Roosevelt Myth, Fox & Wilkes, 1948, 1998, ISBN: 0930073274 and Thomas Fleming, The New Dealers’ War: FDR and the War Within World War II, Basic Books, 2002, ISBN: 0465024653).
Roosevelt’s acceptance speech for the Democratic nomination was widely regarded as a declaration of war against free enterprise. He charged that “economic royalists” were attempting to regain the power they had held until the Depression, and that at every step they were blocking and negating the needed reforms he proposed. FDR’s strategy was to gain the support of workers, farmers and blacks (where they could vote). His tactics included attacks on “big business” and “organised money.” Roosevelt’s 1936 campaign tended to divide and generate fear among the public. The Democratic candidates for president in 1924 and 1928, John W. Davis and Al Smith respectively, publicly deserted FDR and supported his Republican challenger. So too did Roosevelt’s first director of the budget. FDR’s strategy, tactics and policies had very unfortunate economic consequences.
According to Gene Smiley, “the primary explanation for [America’s] slow recovery can be found in the concept of ‘regime uncertainty.’ Especially from 1935 on, the New Deal ravaged the confidence of businessmen. As they became less and less certain that private property rights in their capital and its income stream would be protected and maintained – in other words, uncertain about the continuation of the current ‘regime’ of private property rights – they became less and less willing to make investments, especially longer-term investments in structures and long-lived machinery. Increasingly, only short-term investments with quick payoffs were viewed as desirable. Threats to private property rights may come from many sources, including tax increases, new taxes, confiscation of private property, and business regulation that reduces an owner’s rights over property.”
Governments define private property rights and, in a free society, maintain and defend them. At the heart of every commercial transaction is an exchange of property rights. Accordingly, without clear rules regarding the ownership and exchange of private property and confidence that these rules will be respected in the future, the price system and free enterprise cannot function. To threaten or weaken private property rights, as the Roosevelt Administration did during the 1930s, is to discourage productive and long-term economic activity – especially private investment. Smiley continues: “in retrospect we know that the U.S. did not become some sort of socialist state in the 1930s, but this was not so obvious to many businessmen at the time. Many of the administration’s actions suggested that such a development might very well occur.” New Deal planners made it quite clear that they preferred a planned economy in which government plans would replace individuals’ plans.
Regime uncertainty ordinarily reduces the desire of firms to undertake for longer-term investments. It also depresses the willingness of investors to finance them. Under these conditions, risk premiums appear in the yields of longer-term bonds. According to Smiley, at the end of the 1920s there was virtually no premium on the yields of longer-term bonds. From 1931 to 1934 yields increased slightly. In 1933, for example, the yield on a 30-year bond was 1.6 times the yield on a 1-year bond. Between 1935 and 1941 these differences increased substantially: in 1936 the yield on 10-year bonds was more than four times that on one-year bonds; and the yield on 30-year bonds was more than five times that on one-year bonds.
As the major components of the New Deal were judged unconstitutional or abandoned as unworkable, and as FDR commenced and intensified his attack upon free enterprise, risk premiums increased and remained at historically high levels. After America’s entry into the Second World War, political attacks upon business ebbed greatly (but did not disappear), regime uncertainty diminished considerably and premiums on the yield of longer-term bonds dropped.
Smiley therefore concludes: “the recovery from mid-1935 to mid-1937 and again after the 1937-1938 ‘depression within a depression’ was slow because business was reluctant to invest, expand and undertake potentially risky innovations. They were increasingly uncertain of the rules they were operating under and how secure their property rights were. In the 1930s the Roosevelt administration abruptly and dramatically altered the institutional framework within which private business decisions were made – not just once but several times. The effect was to retard the recovery from the Great Depression of 1929-1933.”
...continued in Part V
RETHINKING
THE GREAT DEPRESSION:
IMPLICATIONS FOR VALUE INVESTORS
Part V
1 June 2003
...continued from Part IV
What we do is look for extremes in markets: very undervalued or very overvalued. Austrian theory has certainly given us an edge. When you have a theory to work from, you avoid the problem that comes with stumbling around in the dark over chairs and nightstands. At least you can begin to visualise in the dark, which is where we all work. The future is always unlit. But with a body of theory, you can anticipate where the structures might lie. It allows you to step out of the way every once in a while.
James Grant
The Austrian Economics Newsletter (1996)
This set of circulars began with the surmise that because we are three generations removed from it, and perhaps also because the images it evokes are so unpleasant and discomfiting, the Great Depression seldom intrudes explicitly into our thoughts. At the same time, however, and in ways that are rarely recognised, certain beliefs and habits that most of today’s investors hold dear were moulded during the late 1920s and 1930s. Perhaps most importantly, beliefs about the proper role, benevolence and general efficacy of government economic management have been strongly influenced if not determined by ideas and actions which gained currency between 1933 and 1945.
Alas, much of what we think that we know about the Depression may be false and many of the lessons we have learnt from it may be mistaken. Sean Corrigan (Six Myths of the Crash) recently reviewed six key planks of contemporary market participants’ intellectual framework. Each is unshakeably mainstream; each derives much of its pedigree from the Great Depression and its aftermath; and each is probably mistaken:
Myth #1: The consumer comprises two-thirds of the economy: as long as she is spending, we can avoid recession.
Myth #2: Lower interest rates and easy credit will promote recovery.
Myth #3: Government spending can promote growth.
Myth #4: All tax cuts are good, and those on dividends will drive equities higher.
Myth #5: We are staring deflation in the face.
Myth #6: Stocks always rise in the long run. Accordingly, the rally will start next quarter, or the quarter after that, or the quarter after that.
Given the tragic and enduring errors committed during the 1930s, Corrigan’s injunction is apposite. Today is “a time for the careful and conservative stewardship of [capital] and for those charged with this to display a willingness to challenge prevailing myths, whether these arise from economic sophistry or from institutional prejudice and intellectual inertia. If we can all become convinced that these are aims well worth achieving [then] this recession might actually turn out to have been fully worth the cost.”
Yet it is vitally important that one’s challenge to prevailing myths does not overstep its mark. James Grant reminds us that politicians and central banks are not responsible for the existence of the business cycle. Slumps, downturns, recessions and depressions occurred during the nineteenth century heyday of the rule of law, free trade, classical gold standard and small government; no set of institutional arrangements, in other words, can generate uninterrupted prosperity. For reasons other than those set in motion by a central bank, investors and businessmen occasionally act like sheep, sometimes like mules and at still other times undertake extreme behaviour. “This is true in specific sectors or financial markets generally. That’s the nature of the market; it gets things wrong and self corrects.” Accordingly, to rethink the Great Depression and to clarify its contemporary implications for value investors is firstly to comprehend the measures that are intended to obviate (but alas, cannot prevent) the errors that the market’s price signals detect and eventually correct. Grant has dubbed certain of these measures and institutions the welfare state of credit. This is a “structure of regulators, lenders, and borrowers, and the system is dedicated to stability, the greatest good of the welfare state of credit … The system is established to avoid runs, panics, depressions, financial turmoil and other upsets. The idea is to head off the contractions before they happen. It is the financial counterpart of the more familiar welfare state of income and of labour. The welfare state of credit is built to resist a repeat of the events of 1907 and 1931.”
The major consequence of these measures is to create moral hazard, i.e., to “promote great bull markets and excessive risk taking in the financial and investment market. The fiscal and labour welfare states generate the perverse effect of feeding the very diseases they are supposedly trying to cure. In a similar way, the welfare state of credit feeds speculative frenzies and excessive risk taking in the financial and investment markets, while attempting to prevent the losses associated with excessive risk taking. It creates the boom that causes the bust, but it attempts to abolish the bust. The long-run consequence is to subsidise instability and economic stagnation in difficult-to-predict ways. The boom-bust can appear in specific sectors and at other times in whole industries. But it doesn’t often appear in extreme ways at the macroeconomic level. The system is designed to prevent that from happening, and it usually does.”
Secondly, to rethink the Great Depression and to clarify its contemporary implications for value investors is to realise the absolute importance of coherent and justifiable frameworks through which to view and render comprehensible economic and financial developments. Benjamin Graham’s ideas, which crystallised during the Depression, constitute a framework for analysing businesses and undertaking investment operations that has demonstrated its worth for seventy years (see in particular Security Analysis: The Classic 1934 Edition, McGraw-Hill, 1996, ISBN: 0070244960 and What Has Worked in Investing). Subsequent successful application of Graham’s principles by a variety of value investors demonstrates that these principles are as relevant during today’s bust as they were in yesterday’s boom and the sequences of boom and bust that preceded them.
So too, as a framework for comprehending economic phenomena, are the insights, analyses and conclusions of the Austrian School of economics (see in particular Israel Kirzner, The Driving Force of the Market: Essays in Austrian Economics, Routledge, 2000, ISBN: 0415228239; Alexander Shand, The Capitalist Alternative: An Introduction to neo-Austrian Economics, New York University Press, 1982, ASIN: 0814778364; and Alexander Shand, Free Market Morality: The Political Economy of the Austrian School, Routledge, 1990, ISBN: 0415041899). In Grant’s prescient words, uttered in 1996, “in the boom cycle, people are not so much interested in a message that says: a bust is simply a necessary part of the business cycle. In a false prosperity, good economic ideas are marginalised. That’s why Austrians should prepare right now to offer the best explanation when the tide turns, as it always does. Who knows? Maybe well find ways to make the bust intellectually profitable. In time, Austrian economics could be again seen as the mainstream theory. It should be.”
THE GREAT DEPRESSION:
IMPLICATIONS FOR VALUE INVESTORS
Part I
1 April 2003
I’m told I can’t use the word depression. Well, I’ll tell you the definition. A recession is when your neighbour loses his job and a depression is when you lose your job. Recovery is when Jimmy Carter loses his.
Ronald Reagan
U.S. Presidential Election (1980)
Perhaps because we are three generations removed from it and the images it evokes are so unpleasant and discomfiting, the Great Depression seldom intrudes explicitly into our thoughts. At the same time, however, and in ways that are rarely recognised, certain beliefs and habits that most of today’s investors hold dear were moulded during the late 1920s and 1930s. Their conceptions of recession and depression; their views about the cause of the Great Depression; their opinions about what ended the Depression; and perhaps most importantly, their beliefs about the proper role, benevolence and general efficacy of government economic management – all have been strongly influenced if not determined by ideas and actions which gained currency between 1929 and 1945.
Unfortunately, however, and as Gene Smiley demonstrates in a new summary of research (Rethinking the Great Depression: A New View of Its Causes and Consequences, Ivan R Dee, 2002, ISBN: 1566634725), much of what we think that we know about the Depression may be false; and many of the lessons we have learnt from it may be mistaken. People act upon ideas, and the ideas adopted at critical junctures – whatever their correspondence to reality – tend to become deeply entrenched. Most of today’s politicians, economists and market participants think and act like their fathers and grandfathers. To do so usually makes good sense: we benefit immeasurably from the cultural and economic inheritance our forebears bequeathed to us.
But not all of our inheritance is sacrosanct, and for this reason Sean Corrigan’s recent injunction to investors and custodians of capital, entitled Six Myths of the Crash, is apposite. Given the tragic and enduring errors committed during the 1930s, today is “a time for the careful and conservative stewardship of [capital] and for those charged with this to display a willingness to challenge prevailing myths, whether these arise from economic sophistry or from institutional prejudice and intellectual inertia. If we can all become convinced that these are aims well worth achieving [then] this recession might actually turn out to have been fully worth the cost.”
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Mainstream Conceptions
A recession is conventionally defined as a rather short period of time, usually 6-18 months, during which the amount and pace of economic activity decreases modestly. Since the Second World War in Anglo-American countries, an increase in the rate of joblessness has usually accompanied a recession. A depression, in turn, is conventionally defined as an extended period of time during which business activity drops significantly. A high rate of unemployment and deflation allegedly occur in tandem with a depression. With the possible exception of New Zealand during the mid 1980s, no Western country has experienced a depression since the 1930s. The term “deflation,” as used by mainstream economists and commentators, refers to a decline in the general level of prices. Its cause can be direct, i.e., through a decrease of demand for goods and services (either in the form of a reduction of spending by governments, capitalists or consumers, or some combination of all three) or indirect, i.e., through a reduction in the supply of money or credit (see also Inflation and Deflation: Some Dissenting Thoughts for Value Investors). Deflation, it is said, is associated with an abrupt increase in the rate of unemployment.
The difference between the terms “recession” and “depression” is indistinct because the definition of neither term is universally agreed. If one asked a group of economists, financiers and business journalists to define them, it is likely that one would receive half a dozen or more separate categories of response. The definition of recession favoured by many journalists and commentators is a decline of Gross Domestic Product (GDP) during two or more consecutive quarters. Many economists dislike this definition because it excludes from consideration changes in other variables such as consumer confidence.
Further, if one relies upon quarterly data then it is rather difficult both to detect a recession and to pinpoint its commencement and termination. A sharp and painful contraction that lasts fewer than six months, for example, may either escape the notice of statisticians – or, given its short duration, fall outside the definition of recession. For this and other reasons, in the U.S. the Business Cycle Dating Committee of the National Bureau of Economic Research determines the extent and type of business activity by looking at a host of economic gauges. These include employment, production, income and wholesale and retail sales. NBER defines a recession as an interval of time between (a) the point when aggregate business activity reaches a peak and starts to fall and (b) the point when it reaches a floor and then begins once again to rise. By this definition, since the Second World War the average recession in the U.S. has lasted approximately 11 months.
Before the Great Depression, any downturn in economic activity, regardless of its length and severity, was called a depression. The term recession was subsequently developed in order to differentiate periods like 1920-21 and the 1930s from the less momentous economic declines that occurred in 1907, 1910 and 1913. Hence the simple but still vague definition of a depression: it is a recession that is unusually long-lived and entails a particularly sharp decline of business activity. How, then, to distinguish a recession and a depression?
A rule of thumb to which a plurality of the mainstream would likely assent is to focus upon changes of GDP. A depression is an economic downturn during which real GDP declines by more than 10 percent; and a recession is a less severe (in time or intensity) downturn. Using this rule of thumb, the last depression in the United States occurred between May 1937 and June 1938. During this 13-month interval real GDP declined by 18.2 percent. If we use this method then in the U.S. the Great Depression of the 1930s can be seen as two separate events: a depression of unprecedented severity that began in August 1929 reached its nadir in March 1933 (and during which real GDP declined by almost 33 percent); a period of recovery; and then a second, and mercifully less severe, depression in 1937-38.
By this method, nothing remotely resembling a depression has been experienced in the U.S. since the late 1930s. Countries such as Finland, Indonesia and possibly New Zealand, however, have suffered depressions during the past 10-15 years. America’s worst recession since the Depression occurred between November 1973 and March 1975: during this period real GDP fell by 4.9 percent. In an outstanding interview conducted in 1996, James Grant, publisher of Grant’s Interest Rate Observer, noted “central bankers may decry one form of inflation. But among the contributions of the Austrians is the insight that there can be an inflation of assets as well as an inflation of prices. In Wall Street and the financial press, inflation means one thing only: the CPI going up. But to students of the Austrian School, that isn’t even half of it.”
So too with the business cycle, recessions and depressions: aggregated national accounts and changes therein, which in various ways are unsatisfactory and incomplete (see, for example, Lawrence Parks, Burn Your House, Boost the Economy, Frank Shostak, What is Up With the GDP? and GNP and Consumer Confidence in Australia: A Dissenting Argument) are not even half of it.
...continued in Part II
RETHINKING
THE GREAT DEPRESSION:
IMPLICATIONS FOR VALUE INVESTORS
Part II
15 April 2003
...continued from Part I
Those readers who have not been introduced to recent scholarship on [this] subject may find some surprising conclusions. The Great Depression is often said to demonstrate the instability of market economies and the need for government oversight and direction. The evidence can no longer support such assumptions. Government efforts to control and direct the gold standard for national purposes brought on the Depression. Once it began, government actions, particularly in the United States, caused it to be much longer and much more severe [than it might otherwise have been]. When the contraction finally ended, government interference in U.S. markets brought on a ‘depression within a depression.’ The 1930s economic crisis is a tragic testimony to government interference in market economies.
Gene Smiley,
Rethinking the Great Depression (2002)
Another Conception of Depression
In a free society, the prices of goods and services are the primary means by which commercial considerations (such as a capitalist’s decision whether or not to build a factory, or a consumer’s decision whether or not to buy a particular good or service) are calculated. Millions of consumers, whose tastes differ from one another and whose preferences change over time, constantly choose among innumerable different commodities and services; similarly, hundreds of thousands of producers, in order to decide what and how much to produce and where to produce it, choose from countless possible resources and methods of production. Accordingly and more generally, prices are also the primary means by which the actions of capitalists, producers and consumers are co-ordinated.
No central planner or committee oversees these myriad choices and decisions. Quite the contrary – in a free society decision-making is decentralised to the level of the individual consumer and producer. Each consumer draws upon information that only she can know (such as her current and prospective income and budget, preference for one good or service vis-à-vis another and the next-best use of the resources at one’s disposal) in order to decide which combination of goods and services, and how much of each, she will purchase. Individual consumers’ purchases provide the revenues by which producers demand the resources necessary to produce the goods and services desired by consumers; and the payments to the owners of resources provide the incomes with which, as consumers, they can demand various commodities and services.
Prices co-ordinate these activities. (I, Pencil by Leonard Read is an outstanding elaboration of the indispensable role of the price system as a mechanism that co-ordinates the actions of myriad people.) More importantly, prices provide the means by which each individual contributes a sliver of knowledge to a whole that no one individual, committee or central planner can possibly command. As an example, if tastes change such that at given prices consumers demand more beef and less of other meats, then they will seek to purchase more beef and less beef-substitutes such as mutton, fish, pork, etc. If so, then the prices of beef will tend to rise and those of other meats will tend to fall. In response to the signals and hence economic incentives generated by these absolute and relative changes of prices, graziers and other primary producers will seek to produce more beef and less mutton, pork, poultry, and other types of meat.
To the extent that their capital base allows them, in other words, they will seek reallocation of resources away from the production of competing meats and towards the production of beef. Producers are unlikely to possess direct knowledge of consumer preferences and changes therein; indirectly, however, i.e., through the signals transmitted by prices and changes of prices, their incentives quickly change in a manner that is consistent with the alteration of consumers’ tastes. Also in response to these changes of absolute and relative prices, abattoirs will seek to ship more beef (and less mutton, etc.) to wholesalers; wholesalers will seek to ship more beef (and less mutton, etc.) to retailers; and retailers will seek to sell more beef and less of other meats to consumers.
A change in consumers’ preference for beef vis-à-vis other meats, then, has through the price mechanism generated commensurate changes to the structure or chain of production of this commodity from primary producers to final consumers. As with beef and other meats so too with myriad other goods and services: if in one market (say, beef) at the current price the quantity demanded by consumers exceeds the quantity supplied by producers, then in another market(s) at the current price(s) the quantity demanded will tend to be less than the quantity supplied. Changes in the absolute and relative prices in these markets will tend to induce producers and the owners of resources to shift production from the latter markets towards the former market. Price changes will also tend to induce consumers to shift from the former markets (where prices are tending higher) towards the latter market (where prices are stable or tending to fall). In this way prices and changes of prices enforce the sovereignty of consumers and the efficiency of producers. Prices co-ordinate the structure of production that harnesses the actions of producers to the demands of consumers. Countless marginal adjustments of prices and relative prices occur constantly. The effect of these adjustments is to allocate scarce resources towards the production of those goods and services (and in those quantities) that consumers desire.
Prices, then, are simple and content-rich bits of information that enable specialisation and exchange to occur. Prices are a necessary condition of a division of labour; and efficient and specialised exchange co-ordinates production and consumption. Clearly, information never corresponds perfectly to the preferences, incentives and behaviour that it measures; the movement of information through space is never instantaneous; and its interpretation is never flawless. Error and misjudgement, in short, is a necessary accompaniment of a price system. Yet the historical record – particularly an examination of attempts to fix, thwart or suspend prices – indicates that an unfettered system of prices generally works reasonably well (see, for example, Tom Bethell’s eminently readable The Noblest Triumph: Property and Prosperity Through the Ages, Palgrave Macmillan, 1998, ISBN: 0312210833).
A price system enables capitalists and producers to detect and adjust reasonably quickly and efficiently to changes in consumer demand. It also enables them to react to changes in the supply of various resources. In a free market, relative to a hampered market or no market, wastage and unemployment of resources is minimised. The price mechanism is a robust but not an indestructible mechanism. Because prices are the primary co-ordinating agents in a market economy, and because prices are expressed in monetary terms, it follows that disturbances to the monetary system may disrupt the price system’s ability properly to co-ordinate the actions of capitalists, producers and consumers. Indeed, a recession or depression occurs when something – particularly a monetary disturbance – disrupts the relatively smooth and accurate operation of price signals (see in particular Murray Rothbard, A History of Money and Banking in the United States: The Colonial Era to World War II, Ludwig Von Mises Institute, 2002, ISBN: 0945466331). The greater the extent and duration of the disruption, the less the extent to which owners and producers can accurately identify and respond to changes in consumer tastes.
RETHINKING
THE GREAT DEPRESSION:
IMPLICATIONS FOR VALUE INVESTORS
Part III
1 May 2003
...continued from Part II
To understand the nature of the worldwide Great Depression and the severity and greater length of the American contraction, one must … understand something of the nature and characteristics of money. Three essential features are banks and the creation and destruction of money; the role of the Federal Reserve System in creating and destroying money; and the gold standard and fixed exchange rates.
Gene Smiley,
Rethinking the Great Depression (2002)
A Primer on Fractional Reserve Banking
The essence of modern banking is arbitrage: banks borrow from a group of people who are in a position to supply funds (depositors) and lend to another but not completely disjoint group (borrowers) who demand funds. In order to compensate depositors for the use of their funds, banks pay them interest; and to compensate themselves for the risk that inheres in lending, banks charge interest on the funds lent to borrowers. To the extent that they arbitrage successfully, i.e., receive more interest from borrowers than is paid to depositors, and receive principal from borrowers and can return it to depositors, banking is a profitable exercise (see in particular Vera C. Smith, The Rationale of Central Banking and the Free Banking Alternative, The Liberty Fund, 1936, 1990, ISBN: 0865970866; Murray Rothbard, The Mystery of Banking and Murray Rothbard, A History of Money and Banking in the United States: The Colonial Era to World War II, Ludwig Von Mises Institute, 2002, ISBN: 0945466331).
A critical ingredient of banks’ success and failure is the creation and destruction of demand deposits. A modern bank lends what would otherwise be idle balances from depositors’ accounts by creating (or adding to) borrowers’ demand deposits. Borrowers then write cheques in order to spend the borrowed funds. Demand deposits facilitate commercial transactions and are an integral part of the money supply. A depositor’s signature on a cheque authorises his bank to pay a portion of his demand deposit to the bearer of the cheque. As Gene Smiley (Rethinking the Great Depression: A New View of Its Causes and Consequences, Ivan R Dee, 2002, ISBN: 1566634725) notes, there is a crucial difference between demand deposits and other types of money.
By the late nineteenth century, banks in America, Australia, Britain and other countries had generally become “fractional reserve” banks. When a bank clears a cheque it debits a demand deposit; and when a bank’s customer deposits funds into an account the bank credits the customer’s demand deposit. Most of the time, the amount of currency paid when cheques are cleared approximates (and thus offsets) the amount received in the form of new deposits. Given that it is safer and more convenient to hold one’s liquid funds in the form of a demand deposit in a bank rather than notes and coins stuffed under the mattress or buried in the back garden, under normal conditions it is unlikely that all or even many of a bank’s depositors will simultaneously seek to convert their demand deposits into currency. Hence the development of “fractional reserve” banking.
Fractional reserve banks retain only a fraction of their deposit liabilities in their vaults (i.e., in the form of currency reserves); instead, most of their deposit liabilities are lent to borrowers. Banks lend in order to generate the income required to pay the bank’s staff and other expenses, provide dividends for their shareholders and pay interest to their depositors. Other things equal (and assuming that the bank arbitrages successfully between depositors and borrowers and that many depositors will not simultaneously seek to convert their demand deposits into currency), the lower the fraction of deposits held in reserve the more profitable the bank. Hence the perennial risk that banks lend too aggressively (see in particular James Grant, Money of the Mind: Borrowing and Lending in America from the Civil War to Michael Milken, Noonday Press repr. ed. 1994, ISBN: 0374524017).
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A Stylised Example
Gene Smiley provides a stylised example that shows how fractional reserve banking can create (and destroy) money. Let us assume that a gold miner extracts gold nuggets that are worth $5,000, and that a local mint transforms them into $5,000 of gold coins. Also assume that the miner deposits the coins (i.e., converts the coins into a demand deposit with a balance of $5,000) at his local bank. For convenience let us refer to this bank as Bank A. Further, let us assume that the law requires that banks hold a minimum percentage of their deposits in cash reserves composed of either gold coins or currency (bank notes). More specifically, assume that banks are required to hold 12.5% of their deposits as reserves; that as a matter of practice banks retain some additional margin of reserves (above the required minimum) as a precaution against unexpected deposit withdrawals; and that therefore banks normally hold 15% of their deposits in gold and currency.
This amount sits either in the bank’s vault or is a demand deposit at another (probably larger) bank. Accordingly, Bank A would retain $750 of the miner’s $5,000 deposit in reserves and would seek to lend the remainder ($4,250) to creditworthy borrowers. If a borrower obtained a loan, then the bank would lend the money by creating a new demand deposit in the borrower’s name (or by adding to the borrower’s current demand deposit) of an amount equal to the loan. Once the bank had lent its new excess reserves of $4,250, it could make no new additional loans until it obtained additional excess reserves. As Smiley notes, however, the story does not end here.
For simplicity let us assume that a single manufacturing firm borrowed the entire $4,250 and that it used this amount to construct additional space at its factory. Assume as well that the firm that extended the factory received the cheque for $4,250 and that it deposited the cheque in its bank (which we will call Bank B). Bank B sends the cheque to Bank A, where $4,250 is deducted from the borrowing firm’s demand deposit and $4,250 (either in the form of currency, or, more likely a bank cheque) is sent to Bank B. Accordingly, Bank A no longer has excess reserves from the miner’s deposit of $5,000. But Bank B has. More precisely, on its balance sheet it now has a new liability (demand deposit) of $4,250 and new asset (additional cash reserves) of $4,250; but given that it holds 15% of deposits as reserves it will retain only $637.50 in reserves against this new deposit. Bank B can lend its new excess reserves of $3,612.50 by creating (or adding to) a demand deposit for a borrower. When a second borrower spends the $3,612.50 and his cheque clears Bank B, this bank (like Bank A) would have no excess reserves available for loans. But Bank C has. Let us say that the $3,612.50 cheque is deposited in a demand deposit in another bank, and that this bank is called Bank C. It now has excess reserves of $3,070.63 and can lend this amount by creating (or adding to) a borrower’s demand deposit.
Consider the process thus far. A miner has mined $5,000 worth of gold and, after having it struck into coins, deposits it in Bank A. The new $5,000 of gold has been converted into a new demand deposit of $5,000 and the money supply has increased by $5,000. Because banks keep only a fraction of their deposits in reserves, Bank A lent the excess reserves and those became a new demand deposit of $4,250 at Bank B. Bank B then had excess reserves, which became a new demand deposit of $3,612.50 at Bank C. In a fractional-reserve banking system, the “hard money” of $5,000 (i.e., the gold the miner found) has set in train a process that has increased demand deposit money by $12,862.50. Further, the process is not finished because Bank C now has excess reserves. This process of expanding the money supply through the creation of demand deposits can continue until all of the $5,000 in gold is transformed into required and precautionary reserves. Given our assumptions, the miner’s production of $5,000 of money could potentially increase the money supply by $33,333.33 (i.e., $5,000 ÷ 0.15). Fractional-reserve banking thus tends inherently to change the money supply; further, the smaller the reserve fraction the greater the resultant change of the money supply. Given this leverage, relatively small changes in reserves typically create much larger changes in the supply of money.
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Fractional Reserve Banking and Monetary Disturbance
Smiley cites an historical example to illustrate the problems that may arise – indeed, inhere – in fractional reserve banking. On 14 October 1907, an unusually large number of the depositors of five banks in New York City began to convert their demand deposits into currency. The depositors’ preference for currency over deposits exceeded the banks’ ability to convert deposits into currency: trouble at these institutions therefore brewed. On 21 October, the Knickerbocker Trust Co. experienced a severe “run” on its deposits and failed; and on 24 October, depositors at the second largest trust company in the City began a run on their deposits.
Chastened by this unexpected development, increasingly worried depositors at other banks began to convert their deposits into currency; in a chain reaction, increasingly concerned banks outside New York that held deposits with banks in the City now began to convert those deposits into currency and gold; and depositors at banks in other Eastern cities, observing the unfolding panic in New York, began to convert the deposits at their banks into currency. By late October 1907 a nation-wide banking panic had developed.
Under a fractional reserve banking system, banks cannot instantly pay cash to large numbers of their depositors because the bulk of the deposits are held in an illiquid form, i.e., loans and income-earning securities rather than currency and gold. And in the absence of a central or reserve bank, commercial banks can turn only to the strongest and most solvent among their ranks, if such a bank exists, in order quickly to obtain cash. If large numbers of banks sell their loans and securities in order to obtain cash for their panicky depositors, their concerted action would drive down the prices of the loan books and securities. Under these circumstances the banks would not have sufficient assets to cover their liabilities and would thus be bankrupt.
In 1907 J.P. Morgan’s rock-solid balance sheet and the confidence he and it inspired saved the day and eventually halted the panic. Banks were able to stem the redemption of deposits into currency and gold. They continued to clear cheques and borrowers continued to repay their loans. Just as they had ended previous banking panics, these actions ended the Panic of 1907 (as economic historians subsequently dubbed it). But in its immediate aftermath, as a safety precaution banks increased the percentage of their deposits they kept as cash reserves. And depositors, for a while, held more of their capital in currency and less in demand deposits.
To rebuild their reserves – for example, to increase the percentage of deposits held as reserves from 15% to 20% – banks must reduce their net lending. If borrowers repaid $100,000 of their outstanding loans, for example, then banks might create only $85,000 of new loans. They could do this by increasing interest rates or the terms and conditions of collateral and repayment, or by “calling” (i.e., demanding immediate repayment of) loans: either would reduce the demand for loans. Under these conditions the demand deposits “destroyed” by the repayment of old loans would be larger than the deposits “created” by new loans. Increasing the fractional reserve ratio thus tends to decelerate, halt or reverse the growth of the money supply. The miner’s new $5,000 in gold would result in $25,000.00 of new demand deposits at a 20% reserve ratio versus $33,333.33 at a 15% ratio. Further, and perhaps more importantly, at a 20% ratio each dollar that a depositor converted into currency rather than hold as a demand deposit would require that the banking system destroy $5 of demand deposits. At a 15% reserve ratio each dollar of demand deposits converted into cash required the destruction of $6.67 of demand deposits.
Under a regime of fractional reserve banking, then, relatively small changes in reserves eventually generate much larger changes in the money supply. In 1907 banks responded to the October runs by accumulating but not lending excess reserves. The money supply subsequently shrank, the pace of economic activity (which had hitherto depended upon debt finance) decelerated and prices (including the price of labour) fell precipitously. The rapid decrease of many prices, which was unrelated to the preferences and demands of consumers, drastically but temporarily weakened the ability of the price mechanism smoothly, accurately and efficiently to co-ordinate the actions of capitalists, producers and consumers. Only when the structure of production adjusted to these new and chastened conditions could prices transmit accurate signals, growth resume and prosperity return.
In 1907, then, a monetary disturbance and the institution of fractional reserve banking transformed what might otherwise have been a brief and relatively minor contraction into a rapid and severe decline of economic activity that persisted until June 1908. During the 1920s and early 1930s, much more severe, complex and extended monetary disturbances occurred. These disturbances, together with politicians’ and policymakers’ utter unwillingness to let the price mechanism operate freely, transformed what might have been a short and sharp contraction of a 1907 or 1920-21 type into a depression of unprecedented severity that lasted throughout the decade.
...continued in Part IV
RETHINKING
THE GREAT DEPRESSION:
IMPLICATIONS FOR VALUE INVESTORS
Part IV
15 May 2003
...continued from Part III
Central bankers, like generals, often are accused of fighting the last war. The [U.S.] Federal Reserve remains haunted by its most humiliating defeat – an utter failure not only to prevent the Great Depression, but its ineptitude in countering the most severe downward spiral in American economic history. That failure arguably has a profound impact on Fed policy to this day.
Barron’s (3 March 2003)
Most monetary economists, particularly those of the Austrian School, have observed the relationship between the supply of money and the pace and sustentation of economic activity. When the central bank increases the supply of money and credit, i.e., generates inflation, interest rates initially fall. Businesses invest this “easy money” and a boom, particularly in the capital goods sector, commences. As the boom matures businesses’ costs increase, interest rates readjust upward and profit margins are squeezed (see Interest Rates, Corporate Debt and the Business Cycle). These effects of central banks’ easy-money policy subsequently dissipate; and the monetary authorities, fearing price inflation, slow the growth of – or even contract – the money supply. In either case, the manipulation of interest rates distorts or falsifies price signals sufficiently to remove the shaky supports underlying the boom (see Inflation and Deflation: Some Dissenting Thoughts for Value Investors).
This crude outline of the business cycle applies (albeit imperfectly) to the late 1920s, late 1990s and other boom-bust sequences (see in particular Great Myths of the Great Depression by the Mackinac Centre for Public Policy). Hence the most fundamental (but hardly the sole) causes of the excesses of the business cycle, including the Great Depression, are fractional reserve banking and central banks. Murray Rothbard’s America’s Great Depression (1963, 2000, Ludwig von Mises Institute, ISBN: 0945466056) is perhaps the most thorough and meticulously documented account of the inflationary actions of the U.S. Federal Reserve during the 1920s. Using a broad measure that includes currency, demand and time deposits, Rothbard estimated that the supply of money in the U.S. grew more than 60 per cent between mid-1921 to mid-1929.
The breakneck expansion of money and credit constitutes what Benjamin Anderson (Economics and the Public Welfare: Financial and Economic History of the United States, 1914-1946, Liberty Fund, 1937, 1980, ISBN: 091396669X) called “the beginning of the New Deal.”
During the 1920s, American monetary authorities actively manipulated the business cycle. They sought to stimulate a boom at home and to assist the Bank of England’s desire to maintain the £ at the rate of exchange that prevailed before the First World War. The resultant flood of credit depressed interest rates, inflated the prices of securities to unprecedented levels and unleashed the “Roaring Twenties.” Producers and consumers made merry, and the Federal Reserve helpfully spiked the punch.
Rothbard shows how the relatively stable prices of the 1920s to a great extent masked the Fed’s inflation and thereby induced many people to think that the gilded prosperity could continue indefinitely. At the same time, technological advancements and entrepreneurial discoveries introduced cheaper ways to produce better goods for more people. This veritable explosion of productivity counteracted much of the upward pressure upon prices generated by the Fed’s policy of inflation. Alas, the distortions and “malinvestments” fostered by the inflation of the money supply cannot continue indefinitely. Every artificial expansion of money and credit introduces imbalances in economic relationships that send false price signals, induce a cluster of entrepreneurial and consumer error and thus set the stage for the downward leg of the business cycle (see, for example, Is Australia Really a Low-Inflation Country?).
This fall is made worse when, by the process outlined in Part III, an increase of the money supply is succeeded by a sudden and severe contraction.
In 1928, the Federal Reserve began to raise interest rates. Its discount rate (the rate charged to member banks for short-term loans) was increased four times, from 3.5 per cent to 6 per cent, between January 1928 and August 1929; and for the next three years it presided over a reduction of the money supply of approximately 30% (see also Milton Friedman and Anna Schwartz, A Monetary History of the United States, 1867-1960, Princeton University Press, 1971, ISBN: 0691003548; and Allan H. Meltzer, A History of the Federal Reserve: Volume 1: 1913-1951, University of Chicago Press, 2003, ISBN: 0226519996). Such a sharp deflation, following so quickly on the heels of the previous inflation, wrenched the economy from tremendous boom to colossal bust. A few analysts contend that the Fed intended this dreadful deflation, but most believe that it badly miscalculated. The result in either case was a manifest failure of monetary policy.
Yet the length and severity of the Great Depression cannot be laid solely at the feet of central bankers: they had much help from politicians. Rothbard’s America’s Great Depression details the many errors of Herbert Hoover (president from 1929 to 1933). His successor, Franklin D. Roosevelt, continued and compounded Hoover’s blunders. FDR was one of the first major political leaders to derive many of his most senior advisers from prestigious academic institutions. These intellectuals rejected the nineteenth century inheritance of black letter law, small government, laissez-faire and the gold standard. Instead, they believed that the U.S. should become a collectivist democracy and therefore that it should embark upon an extensive and intensive program of national economic planning and administrative discretion.
Confirming some people’s worst fears, Roosevelt moved very quickly to alter monetary arrangements radically. The government assigned to itself the authority to control all foreign exchange transactions and all movements of gold and currency. On 5 April 1933, FDR issued an Executive Order that compelled American citizens to surrender all gold certificates and physical gold (except for rare gold coins); on 18 April he prohibited the private export of gold and indicated he would fix the price of gold – an action that augured the devaluation of the $US; and on 5 June, Congress abrogated all gold clauses in contracts. To those who equated gold with money, the sanctity of contract with civil order and stable monetary arrangements with civilisation, the 5 June resolution was a catastrophe. Sen Elmer Thomas, an inflationist from Oklahoma, called it “the most important proposition that has ever come before any parliamentary body of any nation of the world” and rubbed his hands at the prospective transfer of wealth from creditors to debtors. For exactly the same reason, Sen Carter Glass remarked to a friend that “it’s a dishonour … This great government, strong in gold, is breaking its promises to pay gold to widows and orphans to whom it has sold government bonds with a pledge to pay gold coin of the present standard of value.” Sen Thomas Gore of Oklahoma was asked by FDR for an opinion on the gold-clause resolution before it was put to a vote. Quoth the Senator: “why, it’s just plain stealing, isn’t it, Mr President?”
The presidential election campaign of 1936 and the years 1936-1941 introduced overt class warfare into American politics (see also John T. Flynn, The Roosevelt Myth, Fox & Wilkes, 1948, 1998, ISBN: 0930073274 and Thomas Fleming, The New Dealers’ War: FDR and the War Within World War II, Basic Books, 2002, ISBN: 0465024653).
Roosevelt’s acceptance speech for the Democratic nomination was widely regarded as a declaration of war against free enterprise. He charged that “economic royalists” were attempting to regain the power they had held until the Depression, and that at every step they were blocking and negating the needed reforms he proposed. FDR’s strategy was to gain the support of workers, farmers and blacks (where they could vote). His tactics included attacks on “big business” and “organised money.” Roosevelt’s 1936 campaign tended to divide and generate fear among the public. The Democratic candidates for president in 1924 and 1928, John W. Davis and Al Smith respectively, publicly deserted FDR and supported his Republican challenger. So too did Roosevelt’s first director of the budget. FDR’s strategy, tactics and policies had very unfortunate economic consequences.
According to Gene Smiley, “the primary explanation for [America’s] slow recovery can be found in the concept of ‘regime uncertainty.’ Especially from 1935 on, the New Deal ravaged the confidence of businessmen. As they became less and less certain that private property rights in their capital and its income stream would be protected and maintained – in other words, uncertain about the continuation of the current ‘regime’ of private property rights – they became less and less willing to make investments, especially longer-term investments in structures and long-lived machinery. Increasingly, only short-term investments with quick payoffs were viewed as desirable. Threats to private property rights may come from many sources, including tax increases, new taxes, confiscation of private property, and business regulation that reduces an owner’s rights over property.”
Governments define private property rights and, in a free society, maintain and defend them. At the heart of every commercial transaction is an exchange of property rights. Accordingly, without clear rules regarding the ownership and exchange of private property and confidence that these rules will be respected in the future, the price system and free enterprise cannot function. To threaten or weaken private property rights, as the Roosevelt Administration did during the 1930s, is to discourage productive and long-term economic activity – especially private investment. Smiley continues: “in retrospect we know that the U.S. did not become some sort of socialist state in the 1930s, but this was not so obvious to many businessmen at the time. Many of the administration’s actions suggested that such a development might very well occur.” New Deal planners made it quite clear that they preferred a planned economy in which government plans would replace individuals’ plans.
Regime uncertainty ordinarily reduces the desire of firms to undertake for longer-term investments. It also depresses the willingness of investors to finance them. Under these conditions, risk premiums appear in the yields of longer-term bonds. According to Smiley, at the end of the 1920s there was virtually no premium on the yields of longer-term bonds. From 1931 to 1934 yields increased slightly. In 1933, for example, the yield on a 30-year bond was 1.6 times the yield on a 1-year bond. Between 1935 and 1941 these differences increased substantially: in 1936 the yield on 10-year bonds was more than four times that on one-year bonds; and the yield on 30-year bonds was more than five times that on one-year bonds.
As the major components of the New Deal were judged unconstitutional or abandoned as unworkable, and as FDR commenced and intensified his attack upon free enterprise, risk premiums increased and remained at historically high levels. After America’s entry into the Second World War, political attacks upon business ebbed greatly (but did not disappear), regime uncertainty diminished considerably and premiums on the yield of longer-term bonds dropped.
Smiley therefore concludes: “the recovery from mid-1935 to mid-1937 and again after the 1937-1938 ‘depression within a depression’ was slow because business was reluctant to invest, expand and undertake potentially risky innovations. They were increasingly uncertain of the rules they were operating under and how secure their property rights were. In the 1930s the Roosevelt administration abruptly and dramatically altered the institutional framework within which private business decisions were made – not just once but several times. The effect was to retard the recovery from the Great Depression of 1929-1933.”
...continued in Part V
RETHINKING
THE GREAT DEPRESSION:
IMPLICATIONS FOR VALUE INVESTORS
Part V
1 June 2003
...continued from Part IV
What we do is look for extremes in markets: very undervalued or very overvalued. Austrian theory has certainly given us an edge. When you have a theory to work from, you avoid the problem that comes with stumbling around in the dark over chairs and nightstands. At least you can begin to visualise in the dark, which is where we all work. The future is always unlit. But with a body of theory, you can anticipate where the structures might lie. It allows you to step out of the way every once in a while.
James Grant
The Austrian Economics Newsletter (1996)
This set of circulars began with the surmise that because we are three generations removed from it, and perhaps also because the images it evokes are so unpleasant and discomfiting, the Great Depression seldom intrudes explicitly into our thoughts. At the same time, however, and in ways that are rarely recognised, certain beliefs and habits that most of today’s investors hold dear were moulded during the late 1920s and 1930s. Perhaps most importantly, beliefs about the proper role, benevolence and general efficacy of government economic management have been strongly influenced if not determined by ideas and actions which gained currency between 1933 and 1945.
Alas, much of what we think that we know about the Depression may be false and many of the lessons we have learnt from it may be mistaken. Sean Corrigan (Six Myths of the Crash) recently reviewed six key planks of contemporary market participants’ intellectual framework. Each is unshakeably mainstream; each derives much of its pedigree from the Great Depression and its aftermath; and each is probably mistaken:
Myth #1: The consumer comprises two-thirds of the economy: as long as she is spending, we can avoid recession.
Myth #2: Lower interest rates and easy credit will promote recovery.
Myth #3: Government spending can promote growth.
Myth #4: All tax cuts are good, and those on dividends will drive equities higher.
Myth #5: We are staring deflation in the face.
Myth #6: Stocks always rise in the long run. Accordingly, the rally will start next quarter, or the quarter after that, or the quarter after that.
Given the tragic and enduring errors committed during the 1930s, Corrigan’s injunction is apposite. Today is “a time for the careful and conservative stewardship of [capital] and for those charged with this to display a willingness to challenge prevailing myths, whether these arise from economic sophistry or from institutional prejudice and intellectual inertia. If we can all become convinced that these are aims well worth achieving [then] this recession might actually turn out to have been fully worth the cost.”
Yet it is vitally important that one’s challenge to prevailing myths does not overstep its mark. James Grant reminds us that politicians and central banks are not responsible for the existence of the business cycle. Slumps, downturns, recessions and depressions occurred during the nineteenth century heyday of the rule of law, free trade, classical gold standard and small government; no set of institutional arrangements, in other words, can generate uninterrupted prosperity. For reasons other than those set in motion by a central bank, investors and businessmen occasionally act like sheep, sometimes like mules and at still other times undertake extreme behaviour. “This is true in specific sectors or financial markets generally. That’s the nature of the market; it gets things wrong and self corrects.” Accordingly, to rethink the Great Depression and to clarify its contemporary implications for value investors is firstly to comprehend the measures that are intended to obviate (but alas, cannot prevent) the errors that the market’s price signals detect and eventually correct. Grant has dubbed certain of these measures and institutions the welfare state of credit. This is a “structure of regulators, lenders, and borrowers, and the system is dedicated to stability, the greatest good of the welfare state of credit … The system is established to avoid runs, panics, depressions, financial turmoil and other upsets. The idea is to head off the contractions before they happen. It is the financial counterpart of the more familiar welfare state of income and of labour. The welfare state of credit is built to resist a repeat of the events of 1907 and 1931.”
The major consequence of these measures is to create moral hazard, i.e., to “promote great bull markets and excessive risk taking in the financial and investment market. The fiscal and labour welfare states generate the perverse effect of feeding the very diseases they are supposedly trying to cure. In a similar way, the welfare state of credit feeds speculative frenzies and excessive risk taking in the financial and investment markets, while attempting to prevent the losses associated with excessive risk taking. It creates the boom that causes the bust, but it attempts to abolish the bust. The long-run consequence is to subsidise instability and economic stagnation in difficult-to-predict ways. The boom-bust can appear in specific sectors and at other times in whole industries. But it doesn’t often appear in extreme ways at the macroeconomic level. The system is designed to prevent that from happening, and it usually does.”
Secondly, to rethink the Great Depression and to clarify its contemporary implications for value investors is to realise the absolute importance of coherent and justifiable frameworks through which to view and render comprehensible economic and financial developments. Benjamin Graham’s ideas, which crystallised during the Depression, constitute a framework for analysing businesses and undertaking investment operations that has demonstrated its worth for seventy years (see in particular Security Analysis: The Classic 1934 Edition, McGraw-Hill, 1996, ISBN: 0070244960 and What Has Worked in Investing). Subsequent successful application of Graham’s principles by a variety of value investors demonstrates that these principles are as relevant during today’s bust as they were in yesterday’s boom and the sequences of boom and bust that preceded them.
So too, as a framework for comprehending economic phenomena, are the insights, analyses and conclusions of the Austrian School of economics (see in particular Israel Kirzner, The Driving Force of the Market: Essays in Austrian Economics, Routledge, 2000, ISBN: 0415228239; Alexander Shand, The Capitalist Alternative: An Introduction to neo-Austrian Economics, New York University Press, 1982, ASIN: 0814778364; and Alexander Shand, Free Market Morality: The Political Economy of the Austrian School, Routledge, 1990, ISBN: 0415041899). In Grant’s prescient words, uttered in 1996, “in the boom cycle, people are not so much interested in a message that says: a bust is simply a necessary part of the business cycle. In a false prosperity, good economic ideas are marginalised. That’s why Austrians should prepare right now to offer the best explanation when the tide turns, as it always does. Who knows? Maybe well find ways to make the bust intellectually profitable. In time, Austrian economics could be again seen as the mainstream theory. It should be.”
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